Ooh so Wells Fargo screwed the government out of hundreds of millions of dollars of mortgage insurance by fraudulent underwriting, allegedly. We've all heard big-bank mortgage fraud stories by now and they're usually pretty juicy and smoking-gun-tastic: "shit breathers," etc. And the government claims that WFC submitted somewhere between 6,000 and 50,000 bad loans, while specifically describing a dozen or so in the complaint, presumably cherry-picked for maximum offensiveness. Let's look at one:

92. FHA case number 352-4948464 relates to a property on Martin Luther King Blvd. in Newark, NJ (the "King Blvd. Property"). Wells Fargo underwrote the mortgage for the King Blvd. Property, reviewed and approved it for FHA insurance, and certified that a DE underwriter had conducted the required due diligence on the loan application and that the loan was eligible for HUD mortgage insurance. The mortgage closed on or about July 23, 2003.

93. Contrary to Wells Fargo's certification, Wells Fargo did not comply with HUD rules in reviewing and approving this loan for FHA insurance, and did not exercise due diligence in underwriting the mortgage. Instead, Wells Fargo violated multiple HUD rules, including HUD Handbook 4155.1 ¶¶ 2-3 and 3-1, HUD Handbook 4000.4 ¶ 2-4(c)(5), and Mortgagee Letters 1992-5 and 2001-01.

94. Wells Fargo's violation of HUD Handbook 4155.1 ¶ 2-3 is illustrative of the multiple rules that Wells Fargo violated in approving the King Blvd. Property. HUD underwriting guidelines state that lenders must analyze a mortgage applicant's credit and determine the creditworthiness of the applicant. Specifically, lenders must verify and analyze the borrower's payment history of housing obligations, and obtain written explanations from the borrower of past derogatory credit. HUD Handbook 4155.1 ¶ 2-3. Contrary to this clear requirement, Wells Fargo failed to verify the borrower's history of housing obligations or obtain explanations from the borrower for past derogatory credit. In violating HUD Handbook 4155.1 ¶ 2-3, Wells Fargo endorsed the King Blvd. Property for FHA insurance without sufficiently analyzing the borrower's creditworthiness.

There are two subtly different flavors of mortgage lawsuit.1 In one, a bank builds a thing and sells it to a willing third-party buyer with some set of representations that sound quantitative but that sooooooooooooooooooort of come down to "we got you some mortgages we thought you'd like, here they are." That's what you get when Bear Stearns says "we used our common sense to underwrite these subprime loans"; it's also mostly what you get when you buy CDO-squareds, in some of which you couldn't even get loan-level detail, on the say-so of "Credit Suisse is the CDO manager and they're good people."

That is a market-oriented approach, and you could reasonably question what the market thought it was doing. "Betting on rising housing prices," "assuming that reputational sanctions would prevent banks from selling them terrible loans," and "being complete morons" are all plausible answers, but "holding the underwriting to an explicit set of standards" is for the most part probably not. This maybe makes sense - banks are after all in the business of credit underwriting! - and maybe doesn't - no they're not! - but it was mostly what the private sector did.

The other flavor is this thing: there is a handbook! It has sections and subsections and ¶s! If there's a borrower, and he's got past derogatory credit, gosh darn it you are going to call him, and you are going to ask him "what is up with your past derogatory credit?," and he is going to say "oh, that, let me explain," and he will explain, and you will say "I need that in writing," and he will write it down and send it to you. And it will be in your file.

This is the bureaucratic approach and ... I dunno, does it look better? I am torn. NEEDLESS TO SAY, the mortgage mentioned in the complaint - all of the mortgages mentioned in the complaint - defaulted. (In this case, within nine months, and for $228K.) And yes the FHA wouldn't have insured it had they known that borrower's past derogatory credit had not been explained. If there had been an explanation ... would they have insured it? How good would that explanation need to be? I dunno. It's worth keeping in mind that - per the complaint - the FHA "help[s] low-income and moderate-income families become homeowners by lowering some of the costs of their mortgage loans. FHA mortgage insurance encourages lenders to make loans to creditworthy borrowers who nevertheless might not meet conventional underwriting requirements." So that says "creditworthy," but also probably means something other than "possessing bulletproof credit."

Regardless, if you are determined to screw around, you're gonna screw around, no? Pretty much every bank that made FHA loans has been sued over them: basically, the FHA gave the banks a handbook, wandered off for ten years, and then came back shocked to find that the banks hadn't followed the handbook. So it didn't exactly avoid the credit losses that the private sector suffered.

The bureaucratic approach has an important benefit, though, in that the lawsuits are much simpler. You just say "the handbook says X, you did Y, these loans were ineligible for insurance, give me my money." (Actually, 3x my money: this is a False Claims Act suit for treble damages.) The more subjective fraud cases - "you said you'd use common-sense underwriting and actually used uncommon-nonsense underwriting," or "you didn't tell me the John Paulson who was shorting this synthetic CDO was the John Paulson" - are, um, more subjective. More complicated. Possible to defend. Best brought if you can find emails saying "holy crap I cannot believe that we are selling these mortgages to buyers, because they are bad, so bad as to require the use of a naughty word to fully express their badness, and also we are committing securities fraud."

With the FHA, all you need is some unexplained derogatory credit. You can see why the US Attorney's offices bring these suits, and why they settle for lots of cents on the dollar.

But there is a downside! If you bring enough Bear-Stearns-y suits, banks get the message of "actually use common sense in underwriting, and/or cut out the dumb emails." If you bring enough follow-the-handbook suits, banks get the message of "follow the hell out of the handbook." That's probably good, as far as it goes: the handbook is there to prevent banks from making bad loans, and if they follow it to the letter, they probably won't make many bad loans.2

But I also suspect that the handbook overcorrects - that it requires more written explanations of more things than, say, a common-sense private lender would require to make a loan for its own book. That is mostly a hunch - I do not intend to read the HUD Handbook - but it is a hunch informed by this:

Earlier this year, [small bank CEO Bill] Cosgrove faced a demand from Fannie Mae to repurchase a $103,000 mortgage his bank had made in 2003 after the homeowner in Garfield Heights, Ohio, defaulted in late 2010. The latest example, because the borrower made regular payments for so many years, is proof that the loan put-back process "has become more and more ridiculous," he says. ...

Loan officers say their job used to be fairly straightforward: Determine that a borrower could reasonably repay the loan. Today, they say the goal is to shield themselves from a put-back. This means asking borrowers for reams of documentation — tax returns, bank statements, pay stubs, and appraisals — in order to deliver loans that can't be questioned.

Banks are asking borrowers to explain every deposit into their bank accounts over a few hundred dollars in order to verify that their assets are their own, lest an audit later find that the buyer borrowed cash from a family member.

Fannie and Freddie, being bureaucracies, have a handbook; they never need a fortuitous "look at this shit-breather" email to make a seller buy back a loan. All they need is a missing pay stub. This is a pretty, pretty good way to avoid making bad loans. It just seems to be a good way to avoid making good loans, too.

1. In the text I use "mortgage lawsuit" to mean people who had the credit risk of mortgages (securitization investors, monolines, GSEs, and the FHA) suing people who sold them that credit risk (underwriting banks, securitizing banks). But there are lots of other unrelated flavors: people who took out mortgages, for instance, were screwed in a variety of ways, from abstract documentation failures through fraudulent shunting into high-cost loans all the way up to avian kidnapping, and they're pretty much all suing.

2. I mean, bad FHA insured loans. The pool of available stupidity is vast, we're just talking about one little corner of it here.